Sunday, September 7, 2008

Priceless

4 comments:

Justin,I agree. What is so priceless is that all of us, you, me and every household in America just bought about $25,000 worth of priceless Mortgage Backed Securities each. They are priceless not because they are so valuable, but because the free market won't price them. Yet we paid full price. And that money, the cost, will be extracted from us one way or another, along with interest.

This is interesting. Note that in my last comment here I calculated the cost per household of the Fannie and Freddie bailout to be $25,000. That was my calculation. I did not get that from any other article.

Today, as a client of Europac, I received this email from Peter Schiff. In it he calculated the cost the same as me:

The Price of Sanity in a Time of Madness

In the last few months, many of the investment portfolios recommended by Euro Pacific Capital have experienced the most adverse conditions that I have seen in ten years. At present, the troubles are continuing. Driving the declines has been weakness in foreign currencies that are important to our investors. Some have fallen nearly 20% against the U.S. dollar, pushing down the dollar value of stocks in those markets. Simultaneously oil and gold have seen significant declines from their highs in the early part of 2008, which has punished the share prices of commodity-related stocks. The resulting paper declines in our portfolios have been painful to watch. As I'm sure many of you are aware, all of my own investments adhere strictly to our philosophy, so my concern is not academic.

In such an environment it is natural that some of you may be questioning the basic beliefs that originally led you to Euro Pacific. If economic conditions were unfolding differently than what we had expected, then I would share your concerns. Fortunately for our investors, the scenario that I laid out earlier in the decade, which saw an ugly end to America's bubble economy, is playing out almost exactly as I had predicted.

The problem as I see it is that the vast majority of global investors are still chasing phantoms and clinging to false hopes. I believe the markets have now diverged from reality. This is not the first time in recent history that this has happened. But in the end reality can be defied only so long, and I am absolutely confident that those who refuse to succumb to the madness will be redeemed. Fortunately for virtually all of our clients, by avoiding margin and other investment gimmicks, they are not forced to sell, and are in position to ride out the tempest.

The latest "catalyst" noted for pushing up the dollar is the government's recent bailout of Freddie Mac and Fannie Mae. If the market were functioning rationally, the resulting transference of staggering new liabilities to the U.S. Treasury would have been immediately seen as a catastrophe for the dollar. Instead the dollar has rallied.

I believe this counter intuitive reaction results from two forces. First, by transforming trillions of dollars of suspect mortgage backed securities into seemingly bullet-proof Treasury bonds, the move has sparked a relief rally in the dollar as foreign investors no longer have to worry about defaults or markdowns. In fact, to holders of Fannie and Freddie debt, it no longer matters what happens to the housing market. Home prices can drop another 50%, every single homeowner can default on their mortgage, and bond holders will not lose one dime. This has emboldened foreign investors, and temporarily increased demand for both dollars and Freddie and Fannie debt.

The second force is related to leveraged players, particularly hedge funds, around the globe unwinding their trades. Those who have been short the dollar are now buying those dollars back. Those who have been long gold, oil, and other commodities, are liquidating their positions. This massive, though in my view misguided, rush to the exits is causing sharp counter-trend price movements. However once speculators have been flushed from the market, I expect the primary trends to return stronger than ever.

Had the government done the right thing and not guaranteed Freddie and Fannie debt, I believe we would now be experiencing outright financial crisis. The dollar would be falling sharply along with real estate prices, gold would be soaring and the recession would be deepening. However, by nationalizing Freddie and Fannie, the government has merely delayed the crisis. The borrowed time will cost us dearly, as the day of reckoning will now likely involve much steeper losses for our currency.

$5.5 trillion dollars of formerly privately held mortgage backed securities are now, in effect, Treasury bonds. In addition, over the next year or two, my guess is that several trillion dollars of existing mortgages, not currently insured by Freddie or Fannie, will be transferred to the pile. Going forward the vast majority of new mortgages made to Americans will be bought by Fannie or Freddie, and will also become the equivalent of U.S. Treasury bonds. Therefore in a few short years there will be in excess of $10 trillion of new obligations for the U.S. Treasury.

The defenders of the bailout claim that Fannie and Freddie debt does not represent true obligations because they are collateralized by homes. But anyone with a casual interest in the current real estate market knows that homes are now only worth a fraction of outstanding mortgage debt. And that fraction gets smaller every day. My guess is that $10 trillion of Federally insured mortgages will result in $2 trillion or more of losses. That amounts to more than $25,000 per American family.

I do not see how the government could possibly cover these losses through legitimate means (taxation or borrowing). To make good, they must rely on the printing press to create money out of thin air. As a result, even though bond holders will get their dollars back, they will lose purchasing power.

The Freddie and Fannie takeover does nothing to address the underlying problems that forced the companies into bankruptcy. All the bad mortgage debt still exists. In fact, based on this bailout, there will be trillions more in bad mortgages insured over the next few years. The only thing that has changed is how the losses will be distributed. Instead of falling solely on bond holders, who had chosen to invest in mortgage debt, they will now be dispersed among U.S. taxpayers and all holders of U.S. dollars, who made no such choices.

It is my guess that annual Federal budget deficit will soon approach, and then exceed, $1 trillion, and that the national debt, including actual bonds and guaranteed mortgages, will soon exceed $20 trillion. When these untenable obligations force investors to shift focus from default risk to inflation risk, a mass exodus from both Treasuries and mortgage backed securities (now Treasuries in disguise) will ensue.

Right now every asset on the planet is being sold except the U.S. dollar. To me this rally looks like the last gasp of a dying currency. Just like a toy rocket ship, once the dollar runs out of fuel it will crash back down to earth. In the mean time, I realize that it is difficult for Euro Pacific clients to watch the dollar value of their accounts fall every day.

If you see the world as I do, we have no choice but to grin and bear it. The alternative is to sell our foreign stocks and get back into the dollar. However, I am confident that such a course of action will lead to total disaster. I feel sure that any current paper losses in our accounts will be temporary. However, the real losses that will befall holders of U.S. dollars will be permanent.

Total Pageviews

Disclaimer

The above is presented for educational and/or entertainment purposes only. Under no circumstances should it be mistaken for professional investment advice, nor is it at all intended to be taken as such. The commentary and other contents simply reflect the opinion of the author alone on the current and future status of the markets and various economies. It is subject to error and change without notice. The presence of a link to a website does not indicate approval or endorsement of that web site or any services, products, or opinions that may be offered by them.